Susan Athey, NBER and MIT, Andrew Atkeson, NBER and University of California,
Los Angeles, and Patrick J. Kehoe, NBER and University of Minnesota, "On the
Optimality of Transparent Monetary Policy"

Discussant: Jon Faust, Federal Reserve Board

Robert J. Barro, NBER and Harvard University, and Sivana Tenreyro, Harvard
University, "Closed and Open Economy Models of Business Cycles with Marked Up and
Sticky Prices" (NBER Working Paper No. 8043)

Discussant: Mark Bils, NBER and University of Rochester

Christopher Otrok, University of Virginia, B. Ravikumar, Pennsylvania State
University, and Charles H. Whiteman, University of Iowa, "Habit Formation: A
Resolution of the Equity Premium Puzzle?"

Discussant: John C. Heaton, NBER and University of Chicago

Susanto Basu and Miles S. Kimball, NBER and University of Michigan, "Long-Run
Labor Supply and the Elasticity of the Intertemporal Substitution for Consumption"

Discussant: Robert E. Hall, NBER and Stanford University

A fundamentals-based monetary policy rule, which would be optimal without
commitment when private agents have perfectly rational expectations, is unstable if these
agents in fact follow standard adaptive learning rules. This problem can be overcome if
private expectations are observed and suitably incorporated into the policymaker's
optimal rule. These strong results extend to the case in which there is simultaneous
learning by the policymaker and the private agents. Evans and Honkapohja show the
importance of conditioning policy appropriately, not just on fundamentals, but also
directly on observed household and firm expectations.

Swanson offers a possible theoretical explanation for the Federal Reserve's
relatively laissez-faire attitude toward historically low unemployment in the late 1990s.
In models of optimal monetary policy under uncertainty, assumptions must be made
about the structure of the economy and policymakers' beliefs about unobserved and
uncertain variables, such as the natural rate of unemployment. Previous studies in the
literature have made the simplifying assumption that these beliefs have a normal
(Gaussian) distribution. Swanson relaxes this assumption to accommodate beliefs that are
more diffuse (uncertain) in a region around the mean. He argues that this is a more
plausible model given the possibility of structural change that many argued was
occurring in the economy around that time. Swanson demonstrates that it becomes
optimal for policymakers to be more open-minded and set interest rates more cautiously
in response to observable indicators, such as unemployment, while at the same time
becoming increasingly more aggressive at the margin. This model appears to match well
statements by Federal Reserve officials, and the historical behavior of the Fed, in the late
1990s.

Athey, Atkeson, and Kehoe analyze the optimal design of monetary rules. They
suppose that there is an agreed upon social welfare function which depends on the
randomly fluctuating state of the economy and that the monetary authority has private
information about that state. They further suppose that the government can constrain the
policies of the monetary authority by legislating a rule. Surprisingly, the authors show
that for a wide variety of circumstances the optimal rule gives the monetary authority no
flexibility. This rule can be interpreted as a strict inflation targeting rule where the target
is a prespecified function of publicly observed data. In this sense, optimal monetary
policy is transparent.

Shifts in the extent of competition, which affect markup ratios, are possible
sources of aggregate business fluctuations. Markups are countercyclical, and booms are
times at which the economy operates more efficiently. Barro and Tenreyro begin with a
real model in which markup ratios correspond to the prices of differentiated intermediate
inputs relative to the price of undifferentiated final product. If the nominal prices of the
differentiated goods are relatively sticky, then unexpected inflation reduces the relative
price of intermediates and thereby mimics the output effects from an increase in
competition. In an open economy, domestic output is stimulated by reductions in the
relative price of foreign intermediates and, therefore, by unexpected inflation abroad. The
various versions of the model imply that the relative prices of less competitive goods
move countercyclically. The authors find support for this hypothesis from price data of
four-digit manufacturing industries.

Otrok, Ravikumar, and Whiteman explore how the introduction of habit
preferences into the simple intertemporal consumption-based capital asset pricing model
"solves" the equity premium and risk-free rate puzzles. While agents with time-separable
preferences care only about the overall volatility of consumption, the authors show that
agents with habit preferences care not only about overall volatility, but also about the
temporal distribution of that volatility. Specifically, habit agents are much more averse to
high-frequency fluctuations than to low-frequency fluctuations. In fact, the size of the
equity premium in the habit model is determined by a relatively insignificant amount of
high-frequency volatility in the U.S. consumption. Further, the model's premium and
returns are very sensitive to changes in characteristics of the stochastic process for
consumption, changes that have been dramatic during the twentieth century. The model
also carries counterfactual implications the equally dramatic changes in the equity
premium and risk-free rate observed over the last hundred years.

According to Basu and Kimball, the fact that permanent increases in the real
wage have very little effect on labor supply implies a parameter restriction in the
consumption Euler equation augmented by predictable movements in the quantity of
labor. This parameter restriction is confirmed with aggregate U.S. data. The implied
estimate of the elasticity of intertemporal substitution is around .35, and is significantly
different from zero. This estimate is robust to different instrument sets and
normalizations. After accounting for the effects of predictable movements in the labor
implied by the restriction, there is no remaining evidence in aggregate U.S. data of excess
sensitivity of consumption to current income.

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